Market Abuse: Can we leave it to the Market?

Reaction to the UK Government Foresight Report: The Future of Computer Trading in Financial Markets has been mixed (our initial thoughts on the Summary can be found here). Here, we want to talk about market abuse (covered in Foresight section 5.4.1 "leave it to market mechanisms").

Perception is Reality

The Report notes a widespread perception, particularly from the buy-side, that market abuse is prevalent and has been exacerbated by high-frequency trading. But, it can find little empirical evidence of such abuse. The question is, why not? The Foresight Project's research (and other cited work) has looked for abuse in the wrong place. Evidence is apparently unforthcoming from regulators, too. Perhaps they are wrongly equipped or organised to find it, or do not look for it effectively.

But if the buy-side's perceptions are reality, should they wait for academic evidence, or for regulators to get their act together, or abusers to have some ethical epiphany? As someone looking forward to his pension, I hope they don’t wait too long!

More Market Surveillance?

The Report asks, "how might the relationship between computer-based trading and market abuse evolve in the next ten years?" (section 5.4). Briefly, it discusses, "leave it to market mechanisms". Its discussion is weakened by conflating action that traders can take in their own defence, with what venues might do. But the interests of traders and venues are different, and no single venue could solve the entire problem even if it wanted to, as the Report correctly argues. It rather oddly adds, "leaving it to trading venue operators to police abuse thus runs the risk of harming price formation", and "increases the fragmentation of order flow across venues and aggravates order flow imbalances and volatility". If that is so, why do venues undertake any anti‑abuse surveillance at all?

Look Out for Yourself

A trader can do whatever he wants to defend himself (and his clients) from whatever he fears may be harmful. I do not need to know for certain that there is a crazed mugger lurking in the dark alley to decide it might be safer to take another route, or wait till daylight if the whole neighbourhood seems too scary. Traders can do the same. They can travel together, as it were, forming what the Report calls "ingenious new trading systems" for instance.

Or, they can look out for themselves. They could implement solutions which, as the Report puts it, assess, "order flow on each venue by examining patterns in recent activity and giving a ‘green light’ when trading is considered safe". But, the Report refers only to assessing toxicity of order flow.

Bryok goes further. We say that in deciding when, where and how to trade, the integrity of the markets - or apparent lack of integrity - should be taken into account. This should be an essential part of the order execution decision (alongside other best execution criteria: "price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order"). Not only would the trader avoid the potentially damaging lack of integrity on each trade, but over time the whole system will gain integrity. A venue that consistently loses business by failing to ensure its integrity will die or improve. A participant who repeatedly fails to trade because of his lack of integrity will correct the problem.

We think buy-side investors should insist on market integrity; sell-side firms should offer it as part of their order execution policy; execution venues should publish data including it. And that's why we've done something about it - with the creation of Bryok Integrity Metrics™.

Abuse Deniers

The Report appears to be rather dismissive of this idea - it places the words defence mechanisms and solutions in quotation markets. Further, it argues in the context of addressing perceptions of abuse by HFT, rather than dealing with the abuse itself. Why? Are the authors sceptical of the existence, scale and harm of such abuse? Because they have found no direct evidence of it? But nor have they found evidence of the absence of it. As they observe, their "research does not focus on the measurement of market abuse during the continuous phase of trading", ie it neglects the period when abusive HFT activity is likely to take place! Rather than admitting that they just don't know, the conclusion appears to be that the overwhelming opinion of institutional investors should be dismissed as unsubstantiated. Hence it is the ‘perception’ of abuse that must be dealt with, not the abuse itself.

Leave it to the Market

We find the Report over-academic yet rather ill-informed, and the conclusions trivial and missing the point. If policy makers rely on the Report alone, then don’t expect any useful change any time soon. Instead, it is the industry that perceives the problem, and it is the industry that must deal with it, or avoid the effects of it.

If participants value integrity, then "leave it to market mechanisms" turns out to be a very good idea.

Like life, liberty and the pursuit of happiness, many assume that the integrity of securities markets is a self-evidently good thing. IOSCO defines market integrity as "the extent to which a market operates in a manner that is, and is perceived to be, fair and orderly and where effective rules are in place and enforced by regulators so that confidence and participation in the market is fostered."

Others, perhaps more cynical, or more realistic, would say that today's market self-evidently lack integrity. If they did not, the European Commission could not have arrived at an estimate of €13.3 Bn of the cost to investors of abuse of equity markets in the EU alone, for instance. Deliberate market abuse is a major factor impairing market integrity - and is rightly proscribed (though how effectively these proscriptions are enforced is questionnable). However, technical factors, and unexpected systemic behaviour can also impair market integrity. We are not aware of any sensible estimates of the costs due to such factors, but the 2010 Flash Crash offers evidence of their serious consequences.

In this context the current debate over the effects of HFT on market integrity misses the point: the effort and emotion invested in this debate indicates, in IOSCO's terms, that there is a widespread perception - justified or not - that HFT may cause markets to be unfair or disorderly, and hence confidence and participation in the markets is damaged. Without wanting to join this debate we would observe that, if perception is reality, and market integrity depends on perception - as well as objective fact - then HFT has a perception problem, and so do markets that support it.

But while such debates rage, and regulators and legislators get their act together to define and enforce appropriate rules, the world continues to spin, and society needs investors to continue to invest through securities markets. We cannot and need not wait for some perfect system to emerge, even if we could all agree what that system should look like.

Better Execution

So, we have to deal with the world as it is. That means we should not delude ourselves that it is somehow different, or that the consequences are trivial, just-the-way-things-are, or someone else's problem. The cost to investors of neglecting market integrity as a best execution criterion is enormous, as the EC's estimate shows. Conversely, taking market integrity into account when deciding when, where and how to trade creates a substantial opportunity for better execution.

That means when a decision on when, where and how to trade is made, the integrity of the markets - or apparent lack of integrity - should be taken into account alongside "price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order."[1] Buy-side investors should insist on it; sell-side firms should offer it as part of their order execution policy; execution venues should publish data including it[2].

[1] MiFID Article 21, on best execution: a firm must take all reasonable steps to obtain the best possible result for the investor.